The longstanding negative correlation between stock and bond prices is an artifact of the low-inflation environment of the past 30 years. If inflation and inflation expectations continue to rise, investors will have to rethink their portfolio strategies to hedge against the risk of massive future losses.
NEW YORK – Rising inflation in the United States and around the world is forcing investors to assess the likely effects on both “risky” assets (generally stocks) and “safe” assets (such as US Treasury bonds). The traditional investment advice is to allocate wealth according to the 60/40 rule: 60% of one’s portfolio should be in higher-return but more volatile stocks, and 40% should be in lower-return, lower-volatility bonds. The rationale is that stocks and bond prices are usually negatively correlated (when one goes up, the other goes down), so this mix will balance a portfolio’s risks and returns.
During a “risk-on period,” when investors are optimistic, stock prices and bond yields will rise and bond prices will fall, resulting in a market loss for bonds; and during a risk-off period, when investors are pessimistic, prices and yields will follow an inverse pattern. Similarly, when the economy is booming, stock prices and bond yields tend to rise while bond prices fall, whereas in a recession, the reverse is true.
But the negative correlation between stock and bond prices presupposes low inflation. When inflation rises, returns on bonds become negative, because rising yields, led by higher inflation expectations, will reduce their market price. Consider that any 100-basis-point increase in long-term bond yields leads to a 10% fall in the market price – a sharp loss. Owing to higher inflation and inflation expectations, bond yields have risen and the overall return on long bonds reached -5% in 2021.
Over the past three decades, bonds have offered a negative overall yearly return only a few times. The decline of inflation rates from double-digit levels to very low single digits produced a long bull market in bonds; yields fell and returns on bonds were highly positive as their price rose. The past 30 years thus have contrasted sharply with the stagflationary 1970s, when bond yields skyrocketed alongside higher inflation, leading to massive market losses for bonds.